Liquidity Adjustment Facility

Report of the Internal Group on Liquidity Adjustment Facility

Executive SummaryIntroductionSection I Review of Recommendations of Earlier Groups on LAFSection II II.1 Current Monetary Operating Procedure

II.2 Review of Current LAF OperationsII.3 Proposed Modifications to LAF FrameworkII.4 Minimum Quantum Under LAFII.5 Role of the Bank Rate in FutureII.6 Timing of Operations and Future ChallengesII.7 Operations of LAF in the Context of Sterilisation

Section III RecommendationsIII.1 Proposed Modifications in LAF in the Context of day to day Liquidity ManagementIII.2 Proposed Modifications in LAF in the Context of Sterilisation

TablesTable 1 Relative Volumes in Call, Repo (RBI) and Term Money MarketsTable 2 Relative Position of Select Surplus Banks’ Transactions in Call/Notice Market and RBI’s RepoTable 3 Select Banks’ Transactions In Call/Notice Market And RBI’s Repo Under LAFTable 4 Select Banks’ Placement in RBI repo vis-à-vis Lending Operations in Call/Notice MarketTable 5 Changes in Bank Rate, Cash Reserve Ratio and Repo Rate under LAFChartsChart 1 Behaviour of LAF and Call Money RatesChart 2 LAF Corridor when System is in Enduring Deficit ModeChart 3 Spread between Call Rate and Repo Rate and Turnover in call and Repo MarketsChart 4 LAF Corridor when System is in Enduring Surplus ModeChart 5 LAF Corridor

AnnexesAnnex I Recommendations/Action Taken on Report of the Internal Group on Operationalising the

Liquidity Adjustment Facility (LAF) - March 2000Recommendations/Action Taken on the Report of the Internal Group on Review of theLiquidity Adjustment Facility (LAF) – March 2001

Annex II International ExperiencesA. Industrial EconomiesB. Emerging Market Economies

Executive Summary

The mid-term Review of Monetary and Credit Policy for 2003-04 released on November3, 2003 indicated that an Internal Group reviewed the operations of the Liquidity AdjustmentFacility in a cross-country perspective keeping in view recent developments in the financialmarket as well as in technology. The draft Report of the Internal Group was discussed both inthe Technical Advisory Committee on Money and Government Securities Markets (TAC) andthe Financial Markets Committee (FMC) of RBI. Taking into account the comments made byTAC and FMC members, the Report has been revised and is now placed in the public domain forwider comment and debate.

2. The operations of the LAF need to be seen in the context of changes in the transmissionchannels of monetary policy. Since the early 1990s, the monetary targeting approach in theconduct of monetary policy came under stress with increasing interplay of market forces in thedetermination of interest rates and exchange rate as a consequence of deregulation. In addition,the excess liquidity engendered by capital flows imparted an upward pressure on money supply.There was also increasing evidence on changes in the underlying transmission mechanism ofmonetary policy. The Third Working Group on Money Supply (Chairman: Dr.Y.V.Reddy)which submitted its Report in June 1998, found that the output response to monetary policy

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operating through the interest rate tends to be stronger and more persistent than that through thecredit channel. With pricing decisions left increasingly to market forces, the interest rate andexchange rate gained in importance vis-à-vis quantity variables. Accordingly, on a review of themonetary policy framework, RBI gradually switched over to a more broad-based multipleindicator approach.

3. In a quantity based monetary targeting framework, Reserve Money (RM) was used as theoperating target and bank reserves as the operating instrument with broad money (M3) being theintermediate target. In the current monetary operating framework, reliance on direct instrumentsof monetary policy has been reduced and the liquidity management in the system is carried outthrough open market operations (OMO) in the form of outright purchases/sales of governmentsecurities and repo and reverse repo operations under Liquidity Adjustment Facility (LAF). TheOMO are supplemented by access to the Reserve Bank’s standing facilities combined with directinterest rate signals through changes in the Bank Rate/repo rate. In this direction, the LAFintroduced in June 2000 has now emerged as the principal operating instrument of monetarypolicy. The LAF enables the Reserve Bank to modulate short-term liquidity under variedfinancial market conditions in order to ensure stable conditions in the overnight (call) moneymarket. The LAF operates through daily repo and reverse repo auctions thereby setting acorridor for the short-term interest rate consistent with policy objectives. Although there is noformal targeting of overnight interest rates, LAF operation has enabled the Reserve Bank to de-emphasize the targeting of bank reserves and focus increasingly on interest rates. This has alsohelped in reducing CRR without engendering liquidity pressure.

4. While the LAF has emerged as the principal instrument in the monetary policy operatingframework of the Reserve Bank, its operation in the present form in conjunction with othersupporting instruments has given rise to certain conceptual and operational issues which need tobe addressed to enhance the efficacy of monetary operations. The Group identified a number ofmajor issues. First, is the issue concerning the role of the Bank Rate and the repo rate insignalling the stance of monetary policy. While the Bank Rate was envisaged to provide themedium-term signal and the repo rate as the marginal liquidity management rate, there is anincreasing market acceptance of the repo rate as the signalling rate. Thus, there is a need toclarify the relative role of the Bank Rate and the repo rate to impart transparency to monetaryoperations. Second, at present, there is a multiplicity of rates at which liquidity isabsorbed/injected. In an interest rate corridor framework, with the system being in surplusmode, it is generally witnessed that there are normally two rates through which liquidity isabsorbed and one rate through which liquidity is injected, and vice versa when the system is indeficit mode. Keeping this perspective in view, there is a need to rationalize the existingcorridor. Third, since the repo rate has emerged as the policy signalling rate, its relative positionwithin the corridor becomes important. Normally, cross-country experiences show that thepolicy signalling rate is placed in the middle of the corridor. However, in the present framework,the repo rate has been acting as both the policy rate as well as the rate for passive sterilization ofexcess liquidity emanating from capital flows. Hence, the LAF repo rate is placed at the bottomof the corridor which compromises its role as an exclusive policy signalling rate. Fourth, there ismerit in conceptually, though not operationally, distinguishing the sterilisation objectives of theLAF repo facility which is supposed to sterilize surplus funds of a “temporary” nature asopposed to a facility which should be capable of handling surplus funds of a somewhat“enduring” nature. Keeping this in view, it would be desirable to de-emphasize the passivesterilization attribute of the LAF repo facility so that it could emerge as the exclusive policysignalling rate. There is, therefore, a need for adequate instruments of sterilisation in addition tothe liquidity management facilities. Fifth, placement of funds under the LAF repo windowshould normally take place as a matter of last resort. However, with persistence of excess

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liquidity the LAF window is treated as an absorber of funds of the first resort by marketparticipants, thereby affecting adversely the balanced development of various segments of themoney market as also the emergence of a proper rupee yield curve. Sixth, normally centralbanks have a standing deposit facility that provides the floor to the interest rate corridor and actsas the absorber of funds of the last resort. Such a facility is not available with Reserve Bank atpresent. In such a scenario, the remuneration of eligible cash balances under cash reserve ratio(CRR) at the Bank Rate is not compatible with the institution of a standing deposit facility. Thus,there is a need to rationalize the interest rate on eligible cash balances under CRR. In principle,no remuneration is appropriate to make CRR most effective. When remuneration is given, itshould be at the rate at which liquidity is intended to be absorbed, either through LAF operationsor through the standing deposit facility.

5. The monetary policy operating framework on the basis of a cross-country analysis showsthat there are normally two standing facilities: (i) an unlimited collateralized marginal lendingfacility available throughout the day at a premium over the repo rate that provides the upperbound to the corridor, and (ii) a standing uncollateralised unlimited deposit facility availabletowards the closure of the market hours at a discount to the official repo rate that provides thelower bound. Within this corridor, the repo rate (equivalent to the reverse repo rate in India) as adiscretionary instrument for providing liquidity is generally placed in the middle of the corridorin major developed countries so that both the floor rate and the ceiling rates are linked with therepo rate in a well defined and transparent manner.

6. In order to address the set of issues listed above, the Group reviewed the present LAFframework drawing upon experiences in a cross-country perspective. While in the current marketconditions, there is surplus liquidity, the Group examined the operations of LAF under alternatescenarios of the system for both surplus and deficit modes. The major recommendations of theGroup both in respect of day to day liquidity management and in the context of sterilization areas follows:

I. Proposed Modifications in LAF in the Context of day to day Liquidity Management

• In the light of substantial technological developments, the objective of conducting LAFoperation on real-time basis, particularly operationalisation of Negotiated Dealing System (NDS)(i.e., minimum time lag between the auction and communication of results to marketparticipants) on LAF need to be pursued further.

• With a view to achieving balanced development of various segments of the moneymarket, introduction of a deposit facility becomes essential to afford more flexibility to RBI inusing the repo facility as a signalling device while not sacrificing the objective of the provisionof a floor to the movement of short-term interest rates. The deposit facility would also be usefulin mopping up any surplus funds emanating from settlement balances of banks in an RTGSenvironment. Currently, the repo rate provides the lower bound to the interest rate corridor asthe Bank Rate at which eligible cash balances under CRR is remunerated is higher than the reporate. As the repo rate has emerged as the policy signalling rate, there is a need to have a lowerrate linked to the repo rate which could provide a lower bound to the interest rate corridor. Inthis context, the Group explored the feasibility of instituting a standing deposit facility.However, the Reserve Bank of India Act, 1934 in its present form does not permit RBI to borrowon clean basis from banks and pay interest thereon. Therefore, institution of such a depositfacility distinct from CRR for banks would necessitate a suitable amendment to the RBI Act.The Group learnt that the Reserve Bank has already made proposals to the Government to havethe flexibility to change CRR even below the current statutory minimum of 3.0 per cent as also

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to pay interest on such balances actually maintained with it by scheduled banks. The Groupnoted that such amendments are required in the light of the evolving monetary policy framework.

• The Group felt that pending amendments to the RBI Act, the Reserve Bank shouldexplore possibilities of modifying the current CRR provision to accommodate a standing deposittype facility for scheduled banks within its ambit which could achieve the same objective as astanding deposit facility. The Group recommends that banks may be permitted to place depositswith the Reserve Bank at their discretion over and above the required CRR deposits. Suchdeposits may be treated as being placed under standing deposit type facility and be deemed as apart of CRR with a flexible interpretation of the extant provisions of the RBI Act. Thedistinguishing feature of the proposed standing deposit type facility is that the placement ofdeposits under this facility is at the discretion of banks unlike CRR which is applicable to allbanks irrespective of their liquidity position. Thus, the standing deposit type facility as a tool forresidual liquidity management is more efficient as it distinguishes between banks having surpluscash balances from those that are in deficit.

• In the context of LAF, the remuneration of cash balances maintained by banks with theReserve Bank under the standing deposit type facility becomes an important issue. Since theinterest rate on standing deposit type facility is designed to provide a floor to the interest ratecorridor, the remuneration of such deposits should be at a rate lower than the repo rate. A relatedissue is remuneration of eligible cash balances maintained under required CRR for all scheduledbanks. It is felt that with substantial scaling down of CRR coupled with marked decline inoverall interest rate structure in the economy and increasing liquidity needs of participants in thewake of higher interlinkages among different segments of the market, the degree to which CRRhad been impacting banks as an implicit taxation earlier is considerably less in recent period.On balance, the Group, therefore, recommends that in principle, the interest rate on CRR may bealigned with the desired interest rate on the proposed standing deposit type facility. Accordingly,the Group felt that remuneration of eligible cash balances at the Bank Rate is no longerjustifiable and hence, recommends that the remuneration of CRR, if any, be delinked from theBank Rate and placed at a rate lower than the repo rate.

• The minimum tenor of the repo/reverse repo operations under LAF facility should bechanged from overnight to 7 days to be conducted on daily basis to enable balanced developmentof various segments of money market. To facilitate a smooth transition to a system of 7-dayLAF repo, both the overnight and 7-day repo auctions may be conducted on daily basis for aperiod. Even when the overnight repo is phased out, the Reserve Bank should have the option ofconducting overnight repo if the situation so warrants.

• As regards the method of LAF auction, it needs to be appreciated that though the LAFrepo rate emerges from a variable price auction, experience so far indicates that the LAF hasturned out to be a de facto fixed rate auction as market participants do not tend to bid at differentrates. As a result, the Reserve Bank had to conduct fixed rate LAF auctions as and when therepo rate was to be changed. In the proposed framework, the Group recommends that the LAFauction could be a fixed rate auction enhancing its policy signalling rate. However, the ReserveBank should have the flexibility to use the variable price auction format if the situation sowarrants.

• If in future the underlying situation changes from the existing surplus mode to a shortagemode on a more enduring basis, the LAF corridor would need to be redefined within the basicparameters. In such a scenario, there would be two rates at which liquidity would need to beinjected and a single rate at which liquidity would be absorbed. Accordingly, the reverse reporate would be placed within the corridor around which the overnight interest rates are expected to

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fluctuate. As a result, the reverse repo rate (i.e., repo rate by international parlance) wouldbecome the policy signalling rate. The standing deposit facility would continue to remain as thewindow for absorbing residual liquidity. However, the interest rate on the standing depositfacility would have to be determined at a rate lower than the reverse repo policy rate and wouldcontinue to give the lower bound to the interest rate corridor. The upper bound to the corridorwould be provided by a marginal lending facility in the nature of our existing standing refinancefacility at a rate higher than the reverse repo rate. In essence, while the shape of the corridorwould not change, reverse repo rate would replace the repo rate and would become the policysignalling rate around which the overnight call money rates would be expected to fluctuate in theevent the financial market turns into a shortage mode. In such a scenario, the Bank Rate shouldunder normal circumstance be aligned to the marginal lending rate (i.e., standing refinance rate).

• In the international parlance, while “repo” denotes injection of liquidity by the centralbank against eligible collateral, “reverse repo” denotes absorption of liquidity by the central bankagainst eligible collateral. On the contrary, in the Indian context, “repo” denotes liquidityabsorption by the Reserve Bank and “reverse repo” denotes liquidity injection. In order toachieve uniformity and facilitate international comparison, it would be useful to followinternational practice in the usage of the terms “repo” and “reverse repo”.

• The current practice of the minimum bid amount of Rs.5 crore and multiples thereof maycontinue.

• In the recent period, with the economy remaining in surplus mode coupled withdiscretionary liquidity being provided at the reverse repo rate as and when required, theimportance of the Bank Rate as a signalling rate seems to have reduced. It would be desirablethat liquidity injection should take place at a single rate. Accordingly, it would be desirable thatthe Bank Rate is under normal circumstance aligned to the reverse repo rate and, therefore, theentire liquidity support including refinance should be made available at the reverse reporate/Bank Rate. The Bank Rate/reverse repo rate would, therefore, provide the upper bound tothe interest rate corridor. The Group, however, recommends that the Reserve Bank maycontinue to announce the Bank Rate independently as at present, but the Bank Rate should undernormal circumstances stay aligned to the reverse repo rate.

• With intra-day liquidity (IDL) available under the RTGS system, the timing of LAFcould be shifted to the middle of the day, say, 12 noon to ensure that marginal liquidity is kept inthe system for longer time in an environment of RTGS system and low CRR before coming on toRBI's repo window.

• To take care of unforeseen contingencies in mismatches, RBI may consider discretionaryannouncement of timing of both repo auctions and reverse repo auctions at late hours. RBIshould not hold any regular reverse repo auction under LAF towards late hours so as to preventparticipants to fund themselves under this window to extinguish their liability towards IDLavailed earlier during the course of the day from RBI. RBI should, however, keep the depositfacility open towards the end of RTGS system operating hours to absorb any excess fundremaining in the system.

• RBI should strengthen its liquidity forecasting model so as to provide a more scientificbasis to the decision making process for LAF operations.

II. Proposed Modifications in LAF in the Context of Sterilisation

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• In order for the LAF to function as the principal monetary policy instrument forsignalling the Reserve Bank’s stance on interest rates, it is desirable that LAF operates toprimarily manage liquidity at the margin on a day-to-day basis. However, in the recent period,the LAF repo facility has also operated as an instrument of sterilisation. While operationally it isdifficult to distinguish between the sterilisation operations and liquidity management operationsunder LAF, conceptually there is need to distinguish surplus liquidity of “temporary” naturefrom surplus liquidity of a somewhat “enduring” nature. In order to enhance the effectiveness ofLAF, the Group recommends that additional instruments of sterilisation may be explored so as toreduce the liquidity pressure on the LAF window. The Group proposes that as and when the RBIAct is amended, the Standing Deposit Facility could provide an additional instrument ofsterilisation. In the meantime, the Group proposes that a “Standing Deposit Type Facility” couldbe explored within the extant provisions of the Act, without prejudice to the proposedamendment. As proposed by the RBI Working Group on Instruments of Sterilisation, setting upof a Market Stabilisation Fund (MSF) will be useful as an option which can be operationalisedwhenever considered necessary.

• In view of the finite stock of government securities available with the Reserve Bank forsterilisation, particularly, as the option of issuing central bank securities is neither permissibleunder the Act nor considered desirable by the RBI Working Group on Instruments ofSterilisation, the Government may consider setting up of a Market Stabilisation Fund (MSF) tobe created in the Public Account. This Fund could issue a new instrument called MarketStabilisation Bills/Bonds (MSBs) for mopping up enduring surplus liquidity from the systemover and above the amount that could be absorbed under the day to day repo operations of LAF.MSBs may be raised through auctions and permitted to be actively traded in the secondarymarket. The amounts raised would be credited to the Market Stabilisation Fund (MSF). The Fundaccount would be maintained with and managed by the Reserve Bank. The maturity, amount,and timing of issue of MSBs may be decided by the Reserve Bank in consultation with theGovernment depending, inter alia, on the expected duration and quantum of capital inflows, andthe extent of sterilisation of such inflows.

Introduction

The mid-term Review of Monetary and Credit Policy fo r 2003-04 released on November3, 2003 indicated that an Internal Group reviewed the operations of the Liquidity AdjustmentFacility in a cross-country perspective keeping in view recent developments in the financialmarket as well as in technology. The draft Report of the Internal Group was discussed both inthe Technical Advisory Committee on Money and Government Securities Markets (TAC) andthe Financial Markets Committee (FMC) of RBI. The revised Report after taking into accountthe comments made by TAC and FMC members is now placed in public domain for widercomment and debate.

2. In an effort to migrate from direct instruments of monetary control to indirect instrumentsin a market-based economy, a fundamental change in the conduct of monetary policy in Indiawas effected through the introduction of Liquidity Adjustment Facility (LAF) on June 5, 2000.The LAF operations are conducted through daily and 14-day repo/reverse repo auctions. Therates arising out of daily repo and reverse repo auctions have imparted an informal corridor tomovement of call/notice money rates (Chart 1). Thus, LAF as a liquidity management tool hasachieved one of the basic monetary policy objectives of stabilising the short-term interest rates.

3. Since the introduction of LAF, a number of developments have taken place whichnecessitate a fresh look into the operations of LAF. Banks' cash reserve ratio (CRR) has come

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down markedly from 8.5 percent in early April 2000 to 4.5 percent by June 2003. Alongside,standing facilities have also been rationalized substantially: most of the sector-specific refinancefacilities, e.g., food credit refinance, 182-day treasury bill refinance etc., have been phased out;Collateralised Liquidity Facility (CLF) was also phased out by October 2002. Export creditrefinance (ECR) facility is the only sector-specific standing facility that is presently available.However, the actual operations under ECR have been negligible in recent months.

4. On the technology front, the ensuing operationalisation of real-time gross settlement(RTGS) system, centralised funds management system (CFMS), centralised public debt office(PDO) system, frequent net settlement batches etc., in an environment of low CRR are expectedto influence the liquidity requirement of participants in a significant manner. Theimplementation of prudential limits on call/notice money transactions coupled with phasing outof non-banks from this market and the operationalisation of intra-day liquidity (IDL) facilityunder RTGS system would also increase the overall demand for collateral in the system.

Chart 1: Behaviour of LAF and Call Money Rates

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Call Rates Repo Rates Reverse Repo Rate

5. Against this background, as desired by the Governor, an Internal Group was constitutedto review the operations of LAF with the following members:

1. Shri D. Anjaneyulu, Principal Monetary Policy Adviser2. Dr. Narendra Jadhav, Principal Adviser, DEAP3. Dr. T.C. Nair, Chief General Manager, DEIO4. Shri H.R. Khan, Chief General Manager-in-Charge, IDMD5. Shri Deepak Mohanty, Adviser, MPD6. Shri Amitava Sardar, Director, MPD (Co-ordinator and Secretary)

The Group benefitted from discussions with Smt. Usha Thorat, Executive Director, Shri N.V.Deshpande, Principal Legal Adviser, Legal Department, Dr.D.V.S. Sastry, Consultant, MonetaryPolicy Department, Shri Himadri Bhattacharya, CGM, Department of External Investments andOperations (DEIO), Dr. Michael D. Patra, Adviser, Department of Economic Analysis andPolicy (DEAP) and S/Shri Muneesh Kapur, Dhritidyuti Bose and Indranil Sengupta, AssistantAdvisers, DEAP. The Group is also grateful to the members of the Technical Advisory

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Committee on Money and Government Securities Markets (TAC) for their valuable commentsduring their deliberations on October 14, 2003.

6. The Group's Report is organised into three Sections: Section I reviews the majorrecommendations of the earlier two Groups on LAF. Section II examines the current status ofLAF operations and suggests modifications to the LAF framework keeping in view select cross-country experiences. This section also analyses the operations of LAF in the context ofsterilisation of capital inflows. Section III gives recommendations of the Report. An executivesummary has also been given at the beginning of the Report.

Section I

Review of Recommendations of Earlier Groups on LAF

7. As a prelude to the introduction of LAF, an Interim Liquidity Adjustment Facility (ILAF)was introduced in April 1999. In that context, the first internal Group was constituted in May1999 to examine the "Role of the Bank Rate". The Group underlined the need for switching overto a full fledged Liquidity Adjustment Facility (LAF) in three stages. Accordingly, the monetarypolicy Statement of April 2000 announced the introduction of the LAF through a system of repoand reverse repo auctions. The system was operationalised on June 5, 2000.

8. With the experience gained in the operation of the LAF and taking into consideration thefeedback obtained from the market participants at a seminar organised by the Fixed IncomeMoney Market and Derivatives Association of India (FIMMDA) in January 2001, theoperational aspects of the LAF was reviewed by the second internal Group set up for thispurpose. The recommendations of the second internal Group encompassing the new operatingprocedure and auction system were announced in the monetary policy Statement of April 2001.

9. A summary of recommendations of the earlier Groups and their current status areprovided in Annex I. While almost all recommendations of these two internal Groups have beenimplemented in phases, the proposal for LAF operations on a real-time basis (i.e., minimum timelag between the auction and communication of results to market participants) is yet to beimplemented. It was envisaged that following PDO computerisation and operationalisation ofRTGS system, LAF could be conducted on a real-time basis which would include electronicreceipt of bids, automated processing of bids, simultaneous settlement of bids and instantaneousannouncement of results. The Group recommends that in the light of substantial technologicaldevelopments, particularly operationalisation of the Negotiated Dealing System (NDS), theobjective of conducting LAF operations on a real-time basis need to be pursued further.

Section II

II.1 Current Monetary Operating Procedure

10. As highlighted in recent monetary policy statements, "the Bank Rate changes combinedwith CRR and repo rate changes, have emerged as important tools of monetary and liquiditymanagement". While the Bank Rate changes were aimed to reflect changes in the medium-termstance of policy (given the expected growth in real GDP, rate of inflation and demand formoney), variations in LAF rates were expected to facilitate short-term liquidity management inthe financial market on a day-to-day basis. Consequently, variations in the Bank Rate wereexpected to be of lesser frequency reflecting relative stability of medium-term policy stance.Variations in LAF rates on the contrary could be more frequent reflecting day-to-day pressure onmarginal liquidity in the system. However, in practice, since repo and reverse repo rates as partof LAF operations constitute the interest rate corridor, any variation in these rates is perceived by

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the market as short-term interest rate signals arising from change in stance of RBI even when theBank Rate has remained unchanged.

11. This brings to the fore the issue as to which of the rates, viz. the Bank Rate and therepo/reverse repo rates under LAF reflects the policy signalling rate of RBI. In this context,experiences of major developed economies and select emerging markets are given in Annex II.Very briefly stated, the monetary policy operating frameworks in a number of countries showthat it is the standing facilities which provide the corridor within which short-term interest ratesare expected to fluctuate.

12. The monetary policy operating framework on the basis of a cross-country analysis showsthat there are normally two standing facilities: (i) an unlimited collateralised marginal lendingfacility available throughout the day at a rate higher than the repo rate that provides the upperbound to the corridor, and (ii) a standing uncollateralised unlimited deposit facility availabletowards the closure of the market hours at a rate lower than the official repo rate that providesthe lower bound. Within this corridor, the repo rate (equivalent to the reverse repo rate in India)as a discretionary instrument for providing liquidity is generally placed in the middle of thecorridor in major developed countries so that both the floor rate and the ceiling rates are linkedwith the repo rate in a well defined and transparent manner. This operating framework isillustrated in Chart 2.

Chart 2: LAF Corridor when System is in Enduring Deficit Mode

13. In this framework, the repo (reverse repo in the Indian context) rate acts as the policy rateand signals the stance of the central bank. This rate is decided and announced explicitly by thecentral bank from time to time. Therefore, when the repo (reverse repo) rate is changed, theentire corridor shifts as other rates are linked to the repo (reverse repo) rate.

14. In India, on the liquidity absorption side, cash reserve ratio (CRR) has been acting as apassive approximation of standing deposit facility and cash balances between the statutoryminimum level of 3.0 per cent and the required level are remunerated at the Bank Rate.However, there are a number of differences between deposits maintained under CRR andstanding deposit facilities prevailing in other major market economies. First, in India, the CRRis mandated under a statutory provision at the discretion of the Reserve Bank whereas thestanding deposit facility is utilised at the discretion of eligible market participants. Second, thestanding deposit facility is more efficient than CRR in the context that only entities with surplusresources can only avail of this facility wherein CRR applies to all scheduled banks uniformly

Funds

Note: Reverse Repo in Indian context is equivalent to repo in international parlance.

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irrespective of their liquidity position. Third, eligible CRR balances are currently remunerated atthe Bank Rate which is higher than the repo policy rate whereas standing deposit facility shouldideally be available at a rate lower than the repo rate.

15. On the liquidity injection side, the sector-specific export credit refinance facility forbanks and liquidity support to PDs act as a form of marginal lending facility. A portion of thesefacilities are available at the Bank Rate (normal facility) and the remainder at the reverse reporate (back-stop facility). In essence, there are two rates at which currently liquidity injectiontakes place viz., the Bank Rate and the reverse repo rate.

II. 2 Review of Current LAF Operations

16. The operations of the LAF need to be seen in the context of changes in the transmissionchannels of monetary policy. Since the early 1990s, the monetary targeting approach in theconduct of monetary policy came under stress with increasing interplay of market forces in thedetermination of interest rates and exchange rate as a consequence of deregulation. In addition,the excess liquidity engendered by capital flows imparted an upward pressure on money supply.There was also increasing evidence on changes in the underlying transmission mechanism ofmonetary policy. The Third Working Group on Money Supply (Chairman: Dr.Y.V.Reddy)which submitted its Report in June 1998, found that the output response to monetary policyoperating through the interest rate tends to be stronger and more persistent than that through thecredit channel. With pricing decisions left increasingly to market forces, the interest rate andexchange rate gained in importance vis-à-vis quantity variables. Accordingly, on a review of themonetary policy framework, RBI gradually switched over to a more broad-based multipleindicator approach.

17. In a quantity based monetary targeting framework, Reserve Money (RM) was used as theoperating target and bank reserves as the operating instrument with broad money (M3) being theintermediate target. In the current monetary operating framework, reliance on direct instrumentsof monetary policy has been reduced and the liquidity management in the system is carried outthrough open market operations (OMO) in the form of outright purchases/sales of governmentsecurities and repo and reverse repo operations under Liquidity Adjustment Facility (LAF). TheOMO are supplemented by access to the Reserve Bank’s standing facilities combined with directinterest rate signals through changes in the Bank Rate/repo rate. In this direction, the LAFintroduced in June 2000 has now emerged as the principal operating instrument of monetarypolicy. The LAF enables the Reserve Bank to modulate short-term liquidity under variedfinancial market conditions in order to ensure stable conditions in the overnight (call) moneymarket. The LAF operates through daily repo and reverse repo auctions thereby setting acorridor for the short-term interest rate consistent with policy objectives. Although there is noformal targeting of overnight interest rates, LAF operation has enabled the Reserve Bank to de-emphasize the targeting of bank reserves and focus increasingly on interest rates. This has alsohelped in reducing CRR without engendering liquidity pressure.

18. While the LAF has emerged as the princ ipal instrument in the monetary policy operatingframework of the Reserve Bank, its operation in the present form in conjunction with othersupporting instruments has given rise to certain conceptual and operational issues which need tobe addressed to enhance the efficacy of monetary operations. The Group identified a number ofmajor issues. First, is the issue concerning the role of the Bank Rate and the repo rate insignalling the stance of monetary policy. While the Bank Rate was envisaged to provide themedium-term signal and the repo rate as the marginal liquidity management rate, there is anincreasing market acceptance of the repo rate as the signalling rate. Thus, there is a need toclarify the relative role of the Bank Rate and the repo rate to impart transparency to monetaryoperations. Second, at present, there is a multiplicity of rates at which liquidity is

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absorbed/injected. In an interest rate corridor framework, with the system being in surplusmode, it is generally witnessed that there are normally two rates through which liquidity isabsorbed and one rate through which liquidity is injected, and vice versa when the system is indeficit mode. Keeping this perspective in view, there is a need to rationalize the existingcorridor. Third, since the repo rate has emerged as the policy signalling rate, its relative positionwithin the corridor becomes important. Normally, cross-country experiences show that thepolicy signalling rate is placed in the middle of the corridor. However, in the present framework,the repo rate has been acting as both the policy rate as well as the rate for passive sterilization ofexcess liquidity emanating from capital flows. Hence, the LAF repo rate is placed at the bottomof the corridor which compromises its role as an exclusive policy signalling rate. Fourth, there ismerit in conceptually, though not operationally, distinguishing the sterilisation objectives of theLAF repo facility which is supposed to sterilize surplus funds of a “temporary” nature asopposed to a facility which should be capable of handling surplus funds of a somewhat“enduring” nature. Keeping this in view, it would be desirable to de-emphasize the passivesterilization attribute of the LAF repo facility so that it could emerge as the exclusive policysignalling rate. There is, therefore, a need for adequate instruments of sterilization in addition tothe liquidity management facilities. Fifth, placement of funds under the LAF repo windowshould normally take place as a matter of last resort. However, with persistence of excessliquidity the LAF window is treated as an absorber of funds of the first resort by marketparticipants, thereby affecting adversely the balanced development of various segments of themoney market as also the emergence of a proper rupee yield curve. Sixth, normally centralbanks have a standing deposit facility that provides the floor to the interest rate corridor and actsas the absorber of funds of the last resort. Such a facility is not available with Reserve Bank atpresent. In such a scenario, the remuneration of eligible cash balances under cash reserve ratio(CRR) at the Bank Rate is not compatible with the institution of a standing deposit facility. Thus,there is a need to rationalize the interest rate on eligible cash balances under CRR. In principle,no remuneration is appropriate to make CRR most effective. When remuneration is given, itshould be at the rate at which liquidity is intended to be absorbed, either through LAF operationsor through the standing deposit facility.

19. In order to address the above set of issues, the Group reviewed the present LAFframework drawing upon the experiences in a cross-country perspective. While in the currentmarket conditions, there is surplus liquidity, the Group examined the operations of LAF underalternate scenarios of the system being in both surplus and deficit modes.

20. A distinguishing feature of monetary operations in most developed markets is that thefinancial markets at the margin are short in central bank money. Hence, the repo rate (equivalentto reverse repo rate in India) at which liquidity is provided by the central bank has become animportant benchmark within the corridor. While LAF in our context broadly resembles theframework obtaining in developed markets, the principal underlying difference has been surplusliquidity in our system during much of the period since June 2000. Consequently, the repo rateas the liquidity absorption instrument has become very dominant.

21. As the repo rate provides the floor for call rates, it has created some infirmities in thesystem. It has been observed that RBI's LAF repo operations have the tendency to substitutemarket activities in call/notice money, term money and market repo operations. Banks may haveless incentive to lend fully in call/notice market in a scenario of narrow spread between call rateand repo rate. In fact, after taking into account relative credit risk, banks may prefer to lend evenat a marginally lower rate by repoing with RBI than lending in call. This trend has accentuatedsince April 2003 with spread turning negative. This combined with substantial improvement inliquidity has caused call/notice money turnover to shrink from Rs.35,144 crore during 2001-02to Rs.19,920 crore during April-October 2003. Concommittantly, the average amount of repo

12

outstanding with RBI (taking into account both one day and 14-day repo) has increased fromRs.3,503 crore during 2001-02 to Rs.11,196 crore during 2002-03 and further to Rs.29,290 croreduring April- October 2003. The repo amount has witnessed marked upturn particularly fromApril 2003 onwards following call rates falling below the repo rate (Chart 3 and Table 1).

Table 1 : Relative Volumes in Call, Repo (RBI) and Term Money Markets(Rs. Crore)

2001-02 2002-03 2003-04Month Call Avg. Repo Term Call Avg. Repo Term Call Avg. Repo Term

Turnover Outst. Money Turnover Outst. Money Turnover Outst. MoneyApril 35785 10968 41616 8119 225 17338 27372 604May 36458 2132 199 39326 1924 123 18725 25223 455June 38606 2458 283 28905 10420 135 20544 24805 610July 37793 2350 320 32386 17092 108 18698 42690 573August 36891 3243 264 32269 19046 1179 19556 39996 644September 36100 1139 208 28883 19483 247 20584 31373 772October 37539 1325 117 30469 20653 117 23998 13569 543November 32836 4553 125 25821 13859 392December 32681 2469 65 24305 10911 454January 31693 4821 90 24034 6325 288February 33677 3590 290 20682 4259 281March 31667 2986 185 24357 2265 546

Average 35144 3503 195 29421 11196 341 19920 29290 608

Chart 3 : Spread between Call Rate and Repo Rate and Turnover in Call and Repo Market

0

10000

20000

30000

40000

50000

60000

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

Repo Call Spread (Call - Repo)

22. At the same time, it needs to be also recognised that because of LAF repo facility, RBIhas been in a position to hold the rates and provide a floor to call rates. It is, however, desirablethat RBI becomes an absorber of funds of last resort rather than an absorber of funds of firstresort for achieving proper market development and pricing of resources yet providing a firmfloor to the call rates.

23. There is also some perception that banks may use the repo window because of the limitunder call/notice market which came into effect from October 2002. In this regard, the Groupexamined the position of select major lenders in both call market and RBI's repo window. Theselect banks account for 36 percent of aggregate lending in call/notice market and 37 percent of

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repo amount outstanding with RBI. It was found that lending limit in call/notice money marketwas not a constraint, on average, for these banks as a part of their call limit remained unutilised(Table 2).

Table 2: Relative Position of Select Surplus Banks' Transactions in Call/Notice Market andRBI's Repo

(Rs. Crore)A Bank B Bank C Bank D Bank

Month Call lending Repo Call lending Repo Call lending Repo Call lending Repoas % of limit as % of limit as % of limit as % of limit

Dec-02 79 4507 86 1044 60 503 74 1193Jan-03 64 2944 76 400 62 875 74 1063Feb-03 38 3150 103 451 46 183 73 1005Mar-03 68 3788 89 1033 74 506 85 1575Apr-03 43 8821 41 1286 31 2226 57 1231May-03 54 5156 72 1789 23 2112 57 1140Jun-03 66 6336 73 1587 25 2626 66 717Jul-03 48 7605 58 2280 16 2202 56 1420Aug-03 57 5763 75 1523 14 1796 67 1392

The Group felt that a part of call money transactions seems to be migrating to RBI LAF windowthereby adversely affecting the price discovery process in call/notice, term money and repomarkets.

24. Like substitution of call money transactions, the present arrangement may also becontributing to shifting a part of market repo transactions to the repo window of RBI. It wasalso seen that some banks have been purchasing securities under repo with RBI on regular basisto comply with their SLR requirement after borrowing from call market (Table 3). While suchoperations are not prohibited, it needs to be recognised that LAF is a privileged facility extendedto banks to meet, inter alia, temporary unforeseen mismatches. The desired objective isdefeated when banks use the RBI window to meet their SLR needs on regular basis in preferenceto market.

Table 3 : Select Banks' Transactions In Call/Notice Market And RBI's Repo Under LAF(Rs. Crore)

E Bank F Bank G Bank H Bank I BankMonth Net Repo Net Repo Net Repo Net Repo Net Repo

Borr’ng Borr’ng Borr’ng Borr’ng Borr’ngApr-02 36 0 406 100 868 0 594 0 210 0May-02 8 0 308 0 601 0 567 0 241 0Jun-02 21 0 140 0 635 0 337 0 38 0Jul-02 64 0 210 0 691 0 431 0 165 0Aug-02 -14 0 140 0 866 0 284 0 141 0Sep-02 -172 40 293 96 459 195 178 0 59 0Oct-02 -82 173 539 0 593 0 348 0 56 0Nov-02 -68 130 335 0 270 504 119 133 14 60Dec-02 -38 117 101 60 88 233 217 78 0 72Jan-03 -54 96 -58 115 81 50 131 0 57 0Feb-03 -47 85 77 0 -84 228 -87 355 15 41Mar-03 41 100 244 0 147 0 53 241 -6 0Apr-03 57 74 245 28 52 862 56 291 0 90May-03 17 58 34 185 -64 684 -51 194 -21 102Jun-03 -20 105 15 230 -240 754 197 350 -3 96

14

Jul-03 0 156 37 227 -30 450 24 352 -12 225Aug-03 0 224 -21 149 -31 0 -29 355 -27 266Net Borrowing = Borrowing minus Lending in Call/Notice Market.

25. Though LAF has been effective in modulating system liquidity at the margin on a day today basis, the LAF repo rate has become the benchmark rate for the financial market. However,LAF repo rate providing the floor to the movement of short-term interest rates has thedisadvantage of hindering market developments as it provides a safe haven to marketparticipants.

26. With a view to achieving a balanced development of various segments of money marketcoupled with the need to mop up any surplus funds that may remain in the system at the end ofthe day in an environment of RTGS system and low CRR, the Group felt that introduction of astanding deposit facility becomes necessary. This would give RBI more flexibility in using therepo facility in the matter of accepting/rejecting the bids as well as providing a floor formovement of short-term interest rates. The proposed operating procedure is illustrated in Chart4.

Chart 4: LAF Corridor when System is in Enduring Surplus Mode

II.3 Proposed Modifications to LAF Framework

27. The Group was of the view that it would be desirable that liquidity injection should takeplace at a single rate in order to enhance the efficiency of monetary operations. The Group notedthat the Reserve Bank has already taken steps in this direction by aligning the back-stoprefinance rate with the reverse repo rate in the annual monetary policy Statement for 2003-04.Further, the proportion of entitlement under back-stop facility in total refinance has also beenraised to 67 per cent in the Mid-term Review of November 2003. The Group recommends thatthe entire refinance should be made available at the reverse repo rate so that the refinancewindow operates as a marginal lending facility, and along with the Bank Rate/reverse repo rate,it would provide the upper bound to the interest rate corridor.

28. Currently, the repo rate provides the lower bound to the interest rate corridor as theeligible cash balances under CRR is remunerated at the Bank Rate which is higher than the reporate. As the repo rate has emerged as the policy signalling rate, there is a need to have a lowerrate linked to the repo rate which could provide a lower bound to the interest rate corridor. Inthis context, the Group explored the feasibility of instituting a standing deposit facility.

Funds

Note: Repo rate in Indian context is equivalent to reverse repo rate in international parlance.

15

However, the Reserve Bank of India Act, 1934 in its present form does not permit RBI to borrowon clean basis from banks and pay interest thereon. Therefore, institution of such a depositfacility distinct from CRR for banks would necessitate suitable amendment to the RBI Act. TheGroup learnt that the Reserve Bank has already made proposals to the Government to have theflexibility to change CRR even below the current statutory minimum of 3.0 per cent as also topay interest on such balances actually maintained with it by scheduled banks. The Group notedthat such amendments are required in the light of the evolving monetary policy framework.

29. In this context, it needs to be appreciated that the special deposit facility would be in thenature of an uncollateralised standing facility. However, the apprehension that unlimited amountof funds could be placed with RBI under this facility which might dampen the lending activitiesof banks would be unfounded provided the call rates are kept around the policy repo rate. Insuch a scenario, there would be an incentive on the part of market participants to deployresources first in the market on account of higher return that it would fetch and come to RBI onlywhen they would not be in a position to deploy funds around the targeted rate. In the process,the special deposit facility rate would provide a firm floor to the behaviour of call rates while therepo rate would continue to provide the signalling stance from RBI.

30. The Group felt that pending amendments to RBI Act, the Reserve Bank should explorepossibilities of modifying the current CRR provision to accommodate a standing deposit typefacility for scheduled banks within its ambit which could achieve the same objective as astanding deposit facility. The Group recommends that banks may be permitted to place depositswith the Reserve Bank at their discretion over and above the required CRR deposits. Suchdeposits may be treated as being placed under standing deposit type facility and be deemed as apart of CRR with a flexible interpretation of the extant provisions of the RBI Act. Thedistinguishing feature of the proposed standing deposit type facility is that the placement ofdeposits under this facility is at the discretion of banks unlike CRR which is applicable to allbanks irrespective of their liquidity position. Thus, the standing deposit type facility as a tool forresidual liquidity management is more efficient as it distinguishes between banks having surpluscash balances from those that are in deficit.

31. In the context of LAF, the remuneration of cash balances maintained by banks with theReserve Bank under the standing deposit type facility becomes an important issue. Since theinterest rate on standing deposit type facility is designed to provide a floor to the interest ratecorridor, the remuneration of such deposits should be at a rate lower than the repo rate.

32. In this context, a related issue is remuneration of eligible cash balances maintained underrequired CRR for all scheduled banks. If eligible cash balances under CRR are not remunerated,it has the distortive impact of implicit “tax” on the banking system and creates a bias in favour offinancial intermediaries that are not required to maintain such balances. At the same time,excessive remuneration attenuates the effectiveness of reserve requirement as a monetaryinstrument. It is felt that with substantial scaling down of CRR coupled with marked decline inoverall interest rate structure in the economy and increasing liquidity needs of participants in thewake of higher interlinkages among different segments of the market, the degree to which CRRhad been impacting banks as an implicit taxation earlier is considerably less in recent period. Infact, many banks have been using almost their entire CRR balances during the course of the dayfor meeting their payments need. To that extent, such cash balances are maintained more in thenature of a current account. On balance, the Group, therefore, recommends that there is a needto rationalize the interest rate on eligible cash balances under CRR. In principle, noremuneration is appropriate to make CRR most effective. When remuneration is given, it shouldbe at the rate at which liquidity is intended to be absorbed, either through LAF operations orthrough the standing deposit facility. Accordingly, the Group felt that remuneration of eligible

16

cash balances at the Bank Rate is no longer justifiable and hence, recommends that theremuneration of CRR, if any, be delinked from the Bank Rate and placed at a rate lower than therepo rate.

33. With regard to the spread, the Group felt that it should be asymmetric in the sense thatwhile reverse repo rate may be fixed at a higher margin (say, 150 basis points (bps)) on top of therepo rate, the deposit facility rate may be set lower (say, 100 bps) than the repo rate. Thus, thecorridor would have a spread of, say, 250 basis points with the policy repo rate being placedwithin the corridor. The Group recommends that the overnight interest rates should fluctuatearound the repo rate in the corridor.

34. With regard to the minimum tenor of the repo/reverse repo operations under LAF facility,the Group recommends that it should be changed from overnight to 7 days to be conducted ondaily basis to enable balanced development of various segments of money market. In order tofacilitate a smooth transition to a system of 7-day LAF repo, both the overnight and 7-day repoauctions may be conducted on daily basis for a brief period. Even when the overnight repo isphased out, the Reserve Bank should have the option of conducting overnight repo if thesituation so warrants.

35. As regards the method of LAF auction, it needs to be appreciated that though LAF reporate should emerge from a variable price auction, experience so far indicates that LAF has turnedout to be a de facto fixed rate auction as market participants do not tend to bid at different rates.As a result, the Reserve Bank had to conduct fixed rate LAF auctions as and when the repo ratewas to be changed. In the proposed framework, the Group recommends that the LAF auctioncould be conducted at a fixed rate auction enhancing its policy signalling rate. However, theReserve Bank should have the flexibility to use the variable price auction format if the situationso warrants.

36. The distinction between the proposed framework and that obtaining in major developedmarkets is that while only one liquidity injection facility and two liquidity absorption facilitiesare proposed, it is the reverse for developed markets. This reflects the current liquidity conditionwhich has been in surplus mode and hence, the need for two liquidity absorption facilities asopposed to that prevailing in major developed markets where the money market generallyoperates on a shortage mode. Further, the ceiling rate is given by a discretionary facility (i.e.,reverse repo rate) as opposed to a standing facility rate (i.e. marginal lending rate) in operation indeveloped markets. Also, the proposed spread is not uniform on either side of the repo rate withlower spread on the deposit rate. The spread reflects only the prevailing liquidity conditions andmay need to be changed if the situation so warrants in future. The advantage of the system isthat once the spread is explicitly announced, a policy decision to change only the repo rate wouldinduce a corresponding change in the whole corridor automatically.

37. If, however, in future the underlying situation changes from the existing surplus mode to ashortage mode on a more enduring basis, the LAF corridor would need to be redefined within thebasic parameters. In such a scenario, as discussed earlier, there would be two rates at whichliquidity would need to be injected and a single rate at which liquidity would be absorbed.Accordingly, the reverse repo rate would be placed within the corridor around which theovernight interest rates are expected to fluctuate. Accordingly, the reverse repo rate (i.e., reporate by international parlance) would become the policy signalling rate. The standing depositfacility would continue to remain as the window for absorbing residual liquidity. However, theinterest rate on the standing deposit facility would have to be determined at a rate lower than thereverse repo policy rate and would continue to give the lower bound to the interest rate corridor.The upper bound to the corridor would be provided by a marginal lending facility in the nature ofstanding refinance facility at a rate higher than the reverse repo rate. In essence, therefore, while

17

the shape of the corridor would not change, reverse repo rate would replace the repo rate andwould become the policy signalling rate around which the overnight call money rates would beexpected to fluctuate in the event the financial market turns into a shortage mode. In such ascenario, the Bank Rate should under normal circumstance be aligned to the marginal lendingrate (i.e., standing refinance rate). The relative structure of the corridor under shortage mode andsurplus mode and the respective policy signalling rate are illustrated in Chart 5.

Chart 5: LAF Corridor

Note : Reverse Repo (Repo) in Indian context is equivalent to Repo (Reverse Repo) in international parlance.

38. Another issue is the usage of the terminology “repo/reverse repo” as being used in Indianow vis-à-vis those used in advanced economies. In the international parlance, while “repo”denotes injection of liquidity by the central bank against eligible collateral, “reverse repo”denotes absorption of liquidity by the central bank against eligible collateral. “The sale andrepurchase transactions (reverse repo), are sales of assets by the central bank under a contractproviding for their repurchase at a specified price on a given future date; they are used to absorbliquidity” (Instruments of Monetary Management, Issues and Country Experiences, BalinoT.J.T., and Zamalloa L.M., eds., 1997, IMF). On the contrary, in the Indian context, “repo”denotes liquidity absorption by the Reserve Bank and “reverse repo” denotes liquidity injection.In order to achieve uniformity and facilitate international comparison, the Group recommendsthat it would be useful to follow international practice in the usage of the terms “repo” and“reverse repo”.

II.4 Minimum Quantum Under LAF

39. Given the tendency on the part of some participants to place very small amount of fundsof the order of Rs.5-10 crore on RBI repo window, the Group examined the desirability ofraising the current minimum amount of Rs.5 crore for both repo and reverse repo window. Inthis context, it may be mentioned that for the European Central Bank (ECB) also, minimum bidamount for its counterparties has been placed at €1 million for its main refinancing operations.

40. For this purpose, the Group examined the lending operations of select small banks incall/notice money market vis-a-vis their limits and their placements in RBI repo (Table 4). Itwas found that generally banks with smaller lending limit in call/notice market have beencoming to RBI repo to relieve themselves of such limit. Increasing the minimum amount fromRs.5 crore would bar those banks to participate in LAF. The Group, therefore, recommends thatthe current practice of the minimum bid amount of Rs.5 crore and multiples thereof maycontinue.

Table 4: Select Banks’ Placement in RBI Repovis-à-vis Lending Operations in Call/Notice Market

Surplus ModeDeficit Mode

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(Rs.Crore)Parameter G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Bank

I. Lending Limit inCall/NoticeMarket

51 10 99 63 55 38 29 35

II. Average lending inCall/Notice mkt(April-Sept.2003)

30 9 39 53 15 5 19 12

III. Average Amountin RBI Repo (Sept2003)

27 28 22 32 37 27 22 50

II.5 Role of the Bank Rate in Future

41. In recent period, the economy remaining in surplus mode coupled with discretionaryliquidity being provided at the reverse repo rate as and when required, the importance of theBank Rate as a signalling rate seems to have reduced. Bank Rate was used to signal the stance ofpolicy in association with other supporting instruments. The same objective is broadly achievednow through changing the repo rate which is viewed by the market as the benchmark ratesignalling the stance of RBI in the financial market.

Table 5 : Changes in Bank Rate, Cash Reserve Ratio and Repo Rate under LAF

(In Per cent)Date Bank Rate Date CRR Date Repo

22.7.2000 8.00 29.7.2000 8.25 10.10.2000 8.5017.2.2001 7.50 12.8.2000 8.50 24.10.2000 8.252.3.2001 7.00 24.2.2001 8.25 25.10.2000 8.0023.10.2001 6.50 10.3.2001 8.00 20.2.2001 7.5029.10.2002 6.25 19.5.2001 7.50 2.3.2001 7.0029.4.2003 6.00 3.11.2001 5.75 27.4.2001 6.75

29.12.2001 5.50 28.5.2001 6.501.6.2002 5.00 5.3.2002 6.00

16.11.2002 4.75 27.6.2002 5.7514.6.2003 4.50 30.10.2002 5.50

28.2.2003 5.0025.8.2003 4.50

42. It needs to be appreciated here that though LAF volumes reflect the daily marginalliquidity conditions in the system, in effect, the repo rate has started gaining the broader marketacceptance as signal on interest rates from RBI. This is reflected in market participants bidding ata single rate though the LAF auction is a variable price auction. Consequently, the LAF reporate could change only with a direct signal from the RBI. In such a scenario, the repo rate isacquiring the attributes of the Bank Rate. This is also corroborated from internationalexperiences in changes in policy rates. For example, the Fed Funds rate - the policy rate of theFederal Reserve, was changed on 13 occasions between October 2000 and October 2003.Similarly, the main refinancing operations (MRO) repo rate - the policy rate of the ECB, waschanged on 8 occasions during the same period. In India, the repo rate was changed on 12occasions over the same period to achieve the desired objective. In contrast, changes in the BankRate were less frequent. The frequency of changes in the Bank Rate, CRR and repo rate isillustrated in Table 5. A significant message coming out of this Table is that while earlier,changes in the repo rate were preceded by the changes in the Bank Rate, in recent period, the

19

Bank Rate is being changed after the changes in repo rate. In view of these developments, theGroup felt that the repo rate has started reflecting the medium-term stance of RBI and is partlyassuming the role of the Bank Rate. In the process, the repo rate has gained wider acceptance inthe market as a policy signalling rate. Accordingly, it would be desirable that the Bank Rate isaligned to the reverse repo rate and, therefore, the entire liquidity support including refinanceshould be made available at the reverse repo rate/Bank Rate. The Bank Rate/reverse repo ratewould, therefore, provide the upper bound to the interest rate corridor. The Group, however, feltthat while the Bank Rate may continue to be linked to certain specific operations of RBI such asCRR/SLR defaults and General Line of Credit (GLC) to NABARD, its policy signalling effectmay decline in future. The role of the Bank Rate would thus be a liquidity injection rate from theReserve Bank similar to the reverse repo rate. This will also reinforce the upper band of theinterest rate corridor and would enhance the effectiveness of interest rate channel of monetarytransmission. The Group, therefore, recommends that the Reserve Bank may continue toannounce the Bank Rate independently as at present. However, the Bank Rate should undernormal circumstance stay aligned to the reverse repo rate in a liquidity surplus scenario and tothe marginal lending (refinancing) rate in a liquidity deficit scenario.

II.6 Timing of Operations and Future Challenges

43. The emerging financial environment would pose greater challenges to RBI in its conductof monetary policy. This is because coupled with progressive scaling down of CRR tounbinding level, the upgradation of payment system infrastructure in the form ofoperationalisation of CCIL and NDS, the computerisation of PDO and DAD, the expectedcompletion of RTGS system etc., would not only make funds transfer faster and more efficient,call money market may turn more active.

44. The developments in the financial market may call for more rigorous liquidity forecastingas well as conduct of LAF operations at an appropriate time by RBI to smoothen the behaviourof short-term interest rates. Whereas under RTGS system, intra-day liquidity (IDL) would beavailable to eligible market participants, the Group felt that the timing of LAF could be shifted tothe middle of the day, say at 12 noon from the present timing at 10.30 a.m. In fact, PDAI andFIMMDA in the context of their responses to RTGS system issues recently, also desired thatLAF be conducted around 12 noon. This would ensure that marginal liquidity is available in thesystem for longer time for proper adjustment in an environment of RTGS system and low CRRbefore coming on to RBI's repo window.

45. At the same time, the Group appreciated that there could be occasion when the systemmay require liquidity at late hours to take care of unforeseen contingent mismatches. Keepingthis in view, the Group recommended that RBI may consider discretionary announcement oftiming of both repo auctions and reverse repo auctions at late hours. However, the IDL that RBIwould provide for RTGS transactions at nominal cost should not result in overnight rollovers. Inexceptional cases, rollover may be permitted at a very high penal rate. This is the main reasonfor which RBI should not hold any regular reverse repo auction under LAF towards late hours soas to prevent participants to fund themselves under this window to extinguish their liabilitytowards IDL availed earlier during the course of the day from RBI. As a matter of generalpractice, RBI should, however, keep the deposit facility open towards the end of the RTGSsystem operating hours to absorb any excess fund remaining in the system.

46. As regards the forecasting of liquidity for smooth operation of the LAF, daily liquidityforecast would form an important component as indicated in the annual Monetary and CreditPolicy Statement for 2003-04. The Reserve Bank has already developed short-term liquidityforecasting model, the results of which are used by RBI for policy analysis and assessment from

20

November 2002. The Group recommended that RBI should strengthen its liquidity forecastingmodel so as to provide a more scientific basis to the decision making process for LAFoperations. In this regard, steps may need to be taken to make available the key variables such ascurrency in circulation, government’s cash position with RBI and banks’ cash balances with RBIalmost on a real-time basis. The Reserve Bank should also improve the timeliness of itsdissemination of cash balances maintained by banks with it from the current lag of 3 daysfollowing the implementation of CFMS for the banking sector. In this connection, the Grouprecommended that RBI may disseminate the figure for required reserves to be maintained duringthe remaining part of the fortnight to provide more certainty to the market so long as CRRremains binding. Once the liquidity forecasting model is fine tuned, LAF auctions may beconducted on straight-through-process (STP) basis after putting in place the necessarytechnological infrastructure.

II.7 Operations of LAF in the context of Sterilisation

47. In order for the LAF to function as the principal monetary policy instrument forsignalling the Reserve Bank’s stance on interest rates, it is desirable that LAF operates toprimarily manage liquidity at the margin on a day-to-day basis. However, in the recent period,the LAF repo facility has also operated as an instrument of sterilisation. While operationally it isdifficult to distinguish between the sterilisation operations and liquidity management operationsunder LAF, conceptually there is need to distinguish surplus liquidity of “temporary” naturefrom surplus liquidity of a somewhat “enduring” nature. In order to enhance the effectiveness ofLAF, the Group recommends that additional instruments of sterilisation may be explored so as toreduce the liquidity pressure on the LAF window. The Group proposes that as and when the RBIAct is amended, the Standing Deposit Facility could provide an additional instrument ofsterilisation. In the meantime, the Group proposes that a “Standing Deposit Type Facility” couldbe explored within the extant provisions of the Act, without prejudice to the proposedamendment. As proposed by the RBI Working Group on Instruments of Sterilisation, setting upof a Market Stabilisation Fund (MSF) will be useful as an option which can be operationalisedwhenever considered necessary.

48. In view of the finite stock of government securities available with the Reserve Bank forsterilisation, particularly as the option of issuing central bank securities is neither permissibleunder the Act nor considered desirable by the RBI Working Group on Instruments ofSterilisation, the Group considered whether the Government could issue a special variety ofbills/bonds for sterilisation purposes. Unlike in the case of central bank securities where the costof sterilisation is indirectly borne by the fisc, given the consolidated balance sheet approach, thecost of issuance of such instruments by the Government would be directly and transparentlyborne by the fisc. To operationalise such a new instrument of sterilisation and ensure fiscaltransparency, the Group recommends that the Government may consider setting up of a MarketStabilisation Fund (MSF) to be created in the Public Account. This Fund could issue a newinstrument called Market Stabilisation Bills/Bonds (MSBs) for mopping up enduring surplusliquidity from the system over and above the amount that could be absorbed under the day to dayrepo operations of LAF. Issuance of such bills/bonds by the Government will obviate anyconfusion that may arise if RBI also issues its own securities. To impart liquidity to thesebills/bonds, they may be raised through auctions and permitted to be actively traded in thesecondary market. The amounts raised would be credited to the Market Stabilisation Fund(MSF). The Fund account would be maintained with and managed by the Reserve Bank. Thematurity, amount and timing of issue of MSBs may be decided by the Reserve Bank inconsultation with the Government depending, inter alia, on the expected duration and quantumof capital inflows, and the extent of sterilisation of such inflows. As the funds raised throughMSBs would remain immobilized in the RBI books, it would not entail any redemption pressure

21

on Government at the time of maturity. As inflows raised through such bills/bonds will not enterthe Consolidated Fund of the Central Government, it would not form part of the fiscal deficit.Though such bills temporarily add to the Government’s “other liabilities”, the cost of servicingsuch bills would be offset to an extent by larger surplus transfer from the Reserve Bank. (For adetailed account of the issues relating to sterilisation options, please see the Summary of theReport of the Working Group on Instruments of Sterilisation placed on the RBI website.)

Section IIIRecommendations

49. The operations of the LAF need to be seen in the context of changes in the transmissionchannels of monetary policy. While LAF has emerged at the principal instrument in themonetary policy operating framework of the Reserve Bank, its operation in the present form inconjunction with other supporting instruments has given rise to certain conceptual andoperational issues which need to be addressed to enhance the efficacy of monetary operations.Against this background, the Group reviewed the present LAF framework drawing upon theexperiences in a cross-country perspective. The Group has examined the operations of LAFunder alternate scenarios of the system being both in surplus and deficit made. The majorrecommendations of the Group both in respect of day to day liquidity management and in thecontext of sterilisation are as follows:

III.1 Proposed Modifications in LAF in the Context of day to day LiquidityManagement

• In the light of substantial technological developments, the objective of conducting LAFoperations on a real-time basis need to be pursued further.

• Currently, the repo rate provides the lower bound to the interest rate corridor as theeligible cash balances under CRR is remunerated at the Bank Rate which is higher than the reporate. As the repo rate has emerged as the policy signalling rate, there is a need to have a lowerrate linked to the repo rate which could provide a lower bound to the interest rate corridor. Inthis context, the Group explored the feasibility of instituting a standing deposit facility.However, the Reserve Bank of India Act, 1934 in its present form does not permit RBI to borrowon clean basis from banks and pay interest thereon. Therefore, institution of such a depositfacility distinct from CRR for banks would necessitate suitable amendment to the RBI Act. TheGroup learnt that the Reserve Bank has already made proposals to the Government to have theflexibility to change CRR even below the current statutory minimum of 3.0 per cent as also topay interest on such balances actually maintained with it by scheduled banks. The Group notedthat such amendments are required in the light of the evolving monetary policy framework.• The Group felt that pending amendments to RBI Act, the Reserve Bank should explorepossibilities of modifying the current CRR provision to accommodate a standing deposit typefacility for scheduled banks within its ambit which could achieve the same objective as astanding deposit facility. The Group recommends that banks may be permitted to place depositswith the Reserve Bank at their discretion over and above the required CRR deposits. Suchdeposits may be treated as being placed under standing deposit type facility and be deemed as apart of CRR with a flexible interpretation of the extant provisions of the RBI Act. Thedistinguishing feature of the proposed standing deposit type facility is that the placement ofdeposits under this facility is at the discretion of banks unlike CRR which is applicable to allbanks irrespective of their liquidity position. Thus, the standing deposit type facility as a tool forresidual liquidity management is more efficient as it distinguishes between banks having surpluscash balances from those that are in deficit.

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• In the context of LAF, the remuneration of cash balances maintained by banks with theReserve Bank under the standing deposit type facility becomes an important issue. Since theinterest rate on standing deposit type facility is designed to provide a floor to the interest ratecorridor, the remuneration of such deposits should be at a rate lower than the repo rate. A relatedissue is remuneration of eligible cash balances maintained under required CRR for all scheduledbanks. It is felt that with substantial scaling down of CRR coupled with marked decline inoverall interest rate structure in the economy and increasing liquidity needs of participants in thewake of higher interlinkages among different segments of the market, the degree to which CRRhad been impacting banks as an implicit taxation earlier is considerably less in recent period.On balance, the Group, therefore, recommends that there is a need to rationalize the interest rateon eligible cash balances under CRR. In principle, no remuneration is appropriate to make CRRmost effective. When remuneration is given, it should be at the rate at which liquidity is intendedto be absorbed, either through LAF operations or through the standing deposit facility.Accordingly, the Group felt that remuneration of eligible cash balances at the Bank Rate is nolonger justifiable and hence, recommends that the remuneration of CRR, if any, be delinked fromthe Bank Rate and placed at a rate lower than the repo rate.

• It would be desirable that liquidity injection should take place at a single rate in order toenhance the efficiency of monetary operations. Accordingly, the entire refinance should bemade available at the reverse repo rate so that the refinance window operates as a marginallending facility, and along with the Bank Rate/reverse repo rate, it would provide the upperbound to the interest rate corridor.

• With regard to the spread, the Group felt that it should be asymmetric. The corridorwould have a spread of, say, 250 basis points with the policy repo rate being placed within thecorridor. The overnight interest rates should fluctuate around the repo rate in the corridor.

• The minimum tenor of the repo/reverse repo operations under LAF facility should bechanged from overnight to 7 days to be conducted on daily. Even when the overnight repo isphased out, the Reserve Bank should have the option of conducting overnight repo if thesituation so warrants.

• In the proposed framework, the LAF could be conducted at a fixed rate auctionenhancing its policy signalling rate. However, the Reserve Bank should have the flexibility touse the variable price auction format if the situation so warrants.

• In future, if the underlying situation changes from the existing surplus mode to ashortage mode on a more enduring basis, the LAF corridor would need to be redefined within thebasic parameters. In such a scenario, while the shape of the corridor would not change, reverserepo rate would replace the repo rate and would become the policy signalling rate around whichthe overnight call money rates would be expected to fluctuate. In that situation, the Bank Rateshould under normal circumstance be aligned to the marginal lending rate (i.e., standingrefinance rate).

• In order to achieve uniformity and facilitate international comparison, the Grouprecommends that it would be useful to follow international practice in the usage of the terms“repo” and “reverse repo”.• The current practice of the minimum bid amount of Rs.5 crore and multiples thereof maycontinue.• In recent period, the economy remaining in surplus mode coupled with discretionaryliquidity being provided at the reverse repo rate as and when required, the importance of theBank Rate as a signalling rate seems to have reduced. Accordingly, it would be desirable thatthe Bank Rate is aligned to the reverse repo rate and, therefore, the entire liquidity supportincluding refinance should be made available at the reverse repo rate/Bank Rate. The Bank

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Rate/reverse repo rate would, therefore, provide the upper bound to the interest rate corridor.The Bank Rate may continue to be linked to certain specific operations of RBI such as CRR/SLRdefaults and General Line of Credit (GLC) to NABARD, though its policy signalling effect maydecline in future. The role of the Bank Rate would thus be a liquidity injection rate from theReserve Bank similar to the reverse repo rate. The Reserve Bank may continue to announce theBank Rate independently as at present. However, the Bank Rate should under normalcircumstance stay aligned to the reverse repo rate in a liquidity surplus scenario and to themarginal lending (refinancing) rate in a liquidity deficit scenario.• The developments in the financial market may call for more rigorous liquidity forecastingas well as conduct of LAF operations at an appropriate time by RBI to smoothen the behaviourof short-term interest rates. Whereas under RTGS system, intra-day liquidity (IDL) would beavailable to eligible market participants, the timing of LAF could be shifted to the middle of theday, say at 12 noon, from the present timing at 10.30 a.m.

• RBI may consider discretionary announcement of timing of both repo auctions andreverse repo auctions at late hours. RBI should, however, keep the deposit facility open towardsthe end of the RTGS system operating hours to absorb any excess fund remaining in the system.

• RBI should strengthen its liquidity forecasting model so as to provide a morescientific basis to the decision making process for LAF operations. The Reserve Bankshould also improve the timeliness of its dissemination of cash balances maintained bybanks. Once the liquidity forecasting model is fine tuned, LAF auctions may beconducted on straight-through-process (STP) basis after putting in place the necessarytechnological infrastructure.

III.2 Proposed Modifications in LAF in the Context of Sterilisation

• In order for the LAF to function as the principal monetary policy instrument forsignalling the Reserve Bank’s stance on interest rates, it is desirable that LAF operates toprimarily manage liquidity at the margin on a day-to-day basis. However, in the recent period,the LAF repo facility has also operated as an instrument of sterilisation. While operationally it isdifficult to distinguish between the sterilisation operations and liquidity management operationsunder LAF, conceptually there is need to distinguish surplus liquidity of “temporary” naturefrom surplus liquidity of a somewhat “enduring” nature. In order to enhance the effectiveness ofLAF, the Group recommends that additional instruments of sterilisation may be explored so as toreduce the liquidity pressure on the LAF window. The Group proposes that as and when the RBIAct is amended, the Standing Deposit Facility could provide an additional instrument ofsterilisation. In the meantime, the Group proposes that a “Standing Deposit Type Facility” couldbe explored within the extant provisions of the Act, without prejudice to the proposedamendment. As proposed by the RBI Working Group on Instruments of Sterilisation, setting upof a Market Stabilisation Fund (MSF) will be useful as an option which can be operationalisedwhenever considered necessary.

• In view of the finite stock of government securities available with the Reserve Bank forsterilisation, particularly as the option of issuing central bank securities is neither permissibleunder the Act nor considered desirable by the RBI Working Group on Instruments ofSterilisation, the Government may consider setting up of a Market Stabilisation Fund (MSF) tobe created in the Public Account. This Fund could issue a new instrument called MarketStabilisation Bills/Bonds (MSBs) for mopping up enduring surplus liquidity from the systemover and above the amount that could be absorbed under the day to day repo operations of LAF.MSBs may be raised through auctions and permitted to be actively traded in the secondarymarket. The amounts raised would be credited to the Market Stabilisation Fund (MSF). The Fundaccount would be maintained with and managed by the Reserve Bank. The maturity, amount

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and timing of issue of MSBs may be decided by the Reserve Bank in consultation with theGovernment depending, inter alia, on the expected duration and quantum of capital inflows, andthe extent of sterilisation of such inflows.

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Annex I

Recommendations/Action Taken on Report of the Internal Group onOperationalising the Liquidity Adjustment Facility (LAF) - March 2000

Recommendations Status

(i) Summary of Recommendations

Liquidity Adjustment Facility (LAF) in the form ofovernight repos/reverse repos on auction basis forsettlement on the same day may be introduced in phases.Auction may be held on variable interest rate tender basis.Uniform price system may be followed for makingallotment to the successful bidders so that on any day Bankwould announce only one Repo Rates/Reverse Repo rate.

RBI may conduct "Hold-in-Custody" type of repos forabsorbing liquidity. For injecting liquidity, the existingreverse repo procedure may be modified. The proceduralrefinements as suggested by the Group may be adopted forthe purpose.

The transfers of securities under LAF as per the procedurerecommended by the Group should be invariably based onDVP.

Switch over from the existing Interim Liquidity AdjustmentFacility (LAF) to LAF in three phases.

In Stage I, the Additional CLF and Level II could bereplaced by a variable interest rate reverse repos auction fornext day settlement simultaneously the fixed rate reposcould be replaced by the variable interest rate repos auctionagain for next day settlement.

In Stage II, CLF and liquidity support to PDs may bethrough variable rate repos/reverse repos auctions forsettlement on the same day. The cut-off time may be suchthat any post auction adjustment required may be effectivein the market. This stage would require installation of anelectronic bidding and processing system as also transfer ofsecurities through constituent SGL accounts. Stage II couldbe introduced with effect from April 1, 2000. If absolutelyfelt necessary export refinance may be continued in parallel.

In Stage III, RBI can consider Real Time Operations. It isexpected that PDO computerisation and RTGS would beready by them and it should become simple to operate acollateralised LAF even on real time basis. The system

LAF introduced w.e.f.June 5,2000 with uniformprice system

Repo/reverse repoconducted under LAF are‘Hold-in-Custody’type.

Being followed.

Implemented

A part (1/3rd) of ECR,CLF and liquiditysupport is being madeavailable at variable dailyrate linked to LAF cut-off rates.

Proposed to beimplemented with PDOcomputerisation and

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envisaged would include electronic receipt of bids,automation of bid processing, instantaneous resultannouncements after auctions and electronic link with thesecurities settlement system on real time basis.

Minimum assured liquidity support to PDs may becontinued without any assurance on the rate at which thesame is available.

operationalisation ofRTGS system.

Back-stop facilityintroduced.

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Recommendations/Action Taken on the Report of the Internal Group on Review of theLiquidity Adjustment Facility (LAF) – March 2001

Recommendations Status

Discriminatory Price Based Auction for ReverseRepos

The existing system of uniform price basedovernight reverse repos auctions (exceptSaturdays and Holidays) could be replaced withdiscriminatory price based overnight reverserepos auctions with a view to making the marketmore sensitive to trades while bidding. In fact,the varying rates offered on reverse repo areexpected to encourage the market participants togo in for aggressive bidding to reduce their costsrather than going by the bandwagon effect.

Fixed Rate Repo Auctions as Alternative

With a view to providing interest rate signals,RBI could also have the option to switch over tofixed rate volume tender repos on overnight basisas and when felt necessary. For the purpose ofsuch repos the rates of interest tended to beoffered could be announced in advance, a daybefore. These modifications are expected tobring about further flexibility to liquiditymanagement on the one hand and at the sametime facilitate providing signals on interest ratesto the market, on the other.

Backstop Facility

A backstop facility could be made available to thebanks and Primary Dealers. This facility will beavailable on the basis of bank-wise and PD-wiselimits. The norms fixed for working out thelimits will be same as those used for arriving atliquidity support under CLF and Level I. Therate fixed could be 1% over the reverse repo rateat which funds were injected earlier during theday and where no reverse repos bid was acceptedat 3% over repos rate of the day. In case no bidswere accepted earlier during the day at either repoor reverse repo auctions, the rate could be fixed

Implemented (Multiple price auction)with effect from May 8, 2001.

The option has not been frequentlyused; however the fixed rate repooption is exercised at the time ofchange in repo rate.

Back stop facility to banks and PDs is1/2 of their entitlement and the rate isthe same as the reverse repo rate onthat day; when there is no rep/reverserepo auction, then the rate is fixed byRBI on an ad hoc basis keeping inview the relevant factors like previousdays repo rate, NSE-MIBOR rate,liquidity condition etc.

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at 3% over NSE MIBOR as available at 2.30 p.m.This facility would enable Primary Dealers andbanks to prepare themselves for a smoothtransition from the existing system of assuredliquidity support at BR to an environment wheresupport is available only through LAF. PDs andbanks would have to approach DAD each timefor this facility. Rate will be communicated toDAD.

Auction Timing to be Advanced

The LAF auction timing could be advanced by 30minutes to 10.30 a.m. for receipt of bids under thenormal auctions and results will be announcedby12 noon. The bids for the additional reverserepo auction on reporting Fridays could bereceived by 12.15 p.m. and the results announcedby 1 p.m. The backstop facility could be operatedby Primary Dealers, till close of banking hours.

Long Term Repos Not Desirable

Since liquidity being mainly in the hands of a fewentities by virtue of their large size andoperational dimensions, it may not be desirable tofacilitat ethem to lock in funds for longer durationthrough long term repos. Since RBI is aiming ata corridor, its releasing the funds to the marketthrough overnight reverse repo may also not helpmuch as the central bank in a sense would thenonly be recycling the funds thus mopped up.

Timing advanced from 11.00 A.M. to10.30 A.M. and results are beingannounced at 12 o’clock.

14 days repo i.e. on first Monday ofthe reporting fortnight, has since beenintroduced w.e.f. November 5, 2001.The rate has generally been same asthe repo rate. The amounts to beaccepted are decided keeping in view,inter alia,, the liquidity condition thatwould prevail in the next 10-12 days.

For a brief period, repo for 28 dayswas also conducted during October20-24, 2003.

Minimum Bid Amount to be Rs. 5 Crore

The minimum bid size for LAF could be reducedfrom the existing Rs.10 crore to Rs.5 crore to addfurther operational flexibility to the Scheme.

Dissemination of Information

The market could be provided with informationon the scheduled commercial banks' balancecumulatively during the fortnight. Also theweighted average cut off yield in case of multipleprice auction could be communicated to themarket along with results.

Implemented with effect from May 8,2001.

Implemented .

Efforts are being made to reduce thetime lag in respect of disseminationof cash balances of banks’ cashbalances with RBI.

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Auction results along with weightedaverage cut-off yield are beingprovided simultaneously.

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Annex II

International Experiences

The monetary policy operating procedures of select industrial economies viz., theEuropean Central Bank, Bank of England and the Federal Reserve System, and select emergingmarket economies viz., Mexico, Thailand, China and Korea are reviewed below.

A. Industrial Economies

European Central Bank

The liquidity management policy of the ECB is governed by a monetary policy strategyand an operational framework. Monetary policy strategy is a coherent and structured descriptionof all relevant information to provide a foundation for monetary policy decisions consistent withthe ECB’s final objective of price stability. The operational framework is a set of instrumentsand procedures with which ECB strives to maintain short-term interest rates in conformity withthe monetary policy strategy.

Operational Framework

In order to achieve the objectives of the monetary policy strategy, the ECB conducts itsmonetary policy through three types of instruments, viz., open market operations (OMOs),standing facilities and minimum reserve requirement.

Open Market Operations (OMOs)

OMOs are conducted not only to maintain short-term interest rates within a well definedcorridor and to manage liquidity on daily basis but also to provide signal of the stance ofmonetary policy to the market. OMOs can be classified into four categories viz., mainrefinancing operations, longer term refinancing operations, fine-tuning operations and structuraloperations.

First, the main refinancing operations (MROs) which are liquidity injecting (i.e., reverserepo) in nature are held every week in multiple price auctions format with a maturity of twoweeks. MROs constitute the core of the OMOs by which ECB not only provides bulk of therefinancing to the financial sector, the minimum bid rate accepted also reflect the stance of themonetary policy and serves as the benchmark for deciding the rates on standing facilities whichin turn provide corridor to overnight interest rates. Though the MROs are conducted on weeklybasis, the 12 national central banks (NCBs) are required to provide their daily forecast ofliquidity for individual autonomous factors, viz., currency in circulation, government depositsand other autonomous factors (net) to the ECB by 9.30 a.m. which are consolidated by the latterfor the whole of the Eurosystem. Subsequently, forecast errors are worked out on a daily basisby the ECB. It has been estimated that government deposits cause the largest amount of forecasterror. In order to alleviate the impact of uncertainty arising from fluctuations in autonomousfactors in the overall liquidity situation in the Eurosystem, the ECB publishes, each time anMRO is announced, a forecast of autonomous factors upto the day preceding the settlement ofthe subsequent MRO. In fact, except for the forecast of excess reserves, all other relevantinformation is provided to the market by the ECB-the most important being the estimate forreserve requirements published a few days after the start of the monthly maintenance period.The assessment of liquidity condition for the entire banking system constitutes the key elementfor estimating the benchmark allotment rate of each MRO, i.e., minimum bid rate. Since thisrate also reflects the monetary policy stance of the ECB, its proper estimation is very crucial forthe ECB. This rate is set by the Governing Council.

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The longer term refinancing operations are conducted on a monthly frequency with amaturity of three months. These operations represent only a limited part of the aggregaterefinancing volume of the ECB. The ECB does not send signals to the market through theseoperations and normally acts as a rate taker. Further, fine-tuning operations which are mainly inthe nature of liquidity injecting operations are aimed at smoothing out interest rate fluctuationsthat may arise out of unexpected liquidity needs in the economy e.g., millenium changeover,9/11 events etc. Accordingly, their frequency of operations and maturity period are notstandardised. In addition, structural operations are carried out through issuance of debtcertificates, reverse transactions and outright transactions. These are aimed at adjusting thestructural position of the Eurosystem vis-à-vis the financial sector. Their frequency can beregular or irregular.

Standing Facilities

The standing facilities facilitate injection and absorption of overnight liquidity at theinitiative of market participants. The rates on standing facilities impart a corridor within whichovernight rates are allowed to fluctuate. Standing facilities are of two types - marginal lendingfacility and deposit facility. Under normal circumstances, ECB provides unlimited credit undermarginal lending facility, the interest rate of which provides a ceiling to the overnight marketinterest rates. Such interest rate is set at 100 basis points (bps) over the minimum bid rateaccepted under main refinancing operations (MROs). Such a rate forces participants to fundtheir positions from overnight market and/or from MROs of ECB in the first place and turn to themarginal lending facility only as matter of last resort. These are granted either in the form ofovernight repurchase agreements or as overnight collateralised loan. The deposit facility on theother hand enables participants to deposit unlimited amount to their accounts in respectivenational central banks. The interest rate on this facility which is set at 100 bps lower than theminimum bid rate accepted under MROs normally provides a floor to overnight market interestrates. No collateral is given to counterparty in exchange for these deposits. It is worthwhile tonote that though unlimited standing facilities are extended by the ECB, its utilisation remainsvery limited.

Bank of England

The primary aim of the Bank of England’s operations in sterling money market is toimplement the Monetary Policy Committee’s interest rate decisions while meeting the liquidityneeds and so contributing to the stability of the banking system as a whole. In its money marketoperations, the Bank of England satisfies the marginal liquidity demand of the banking system asa whole through open market operations conducted transparently in high quality marketinstruments.

Settlement banks are obliged to maintain a minimum balance of zero on their Bank ofEngland settlement accounts at the end of each day (i.e. there is, in effect, a one-day maintenancerequirement in the United Kingdom, and unlike some other countries’ systems, no positivereserve requirement and no reserve averaging over a maintenance period are required). In itsmoney market operations, the Bank of England provides the liquidity needed by the bankingsystem for same-day settlement and enables the settlement banks to achieve positive end-of-daybalances on these accounts. In this way, it acts as the marginal supplier of money to the bankingsystem enabling effective system-wide liquidity management under normal market conditions.

The short-term nature of the refinancing provided by the Bank of England ensures thatthe banking system almost always has a net shortage of funds each day. This refinancing islargely, although not entirely, conducted via repo transactions which usually have a maturity of

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two weeks (ten working days) by which the Bank of England provides liquidity to marketparticipants. It seeks to provide the system’s daily liquidity requirement at its principal rounds ofoperations at 9.45 a.m. and 2.30 p.m. at the official repo rate set by the Monetary PolicyCommittee (MPC). If it is required that liquidity may need to be provided later in the day,further rounds of operations conducted at 3.30 p.m. and 4.20 p.m. are designed to square-off anyremaining imbalance in the banking system in an orderly manner, usually at a penal rate ofinterest.

While conducting these operations, the Bank of England closely monitors various flowsacross its balance sheet in order to know how much liquidity to supply to market participantseach day. To facilitate this process, the Bank of England publishes a forecast of the daily systemliquidity shortage (the expected amount of refinancing likely to be required) on its wire servicepages each day.

If, as is normally the case, the market is forecast to be short of liquidity and if the forecastshortage exceeds a minimum threshold, the Bank of England invites its counterparties to submitoffers for repos and/or outright sales of bills. The Bank of England also states the interest rate atwhich it is prepared to operate (the repo rate) and the maturity dates for the repos.Counterparties willing to participate in the round have five minutes to bid for the funds that theywish to obtain through repo and/or outright sales of bills. No single counterparty is permitted tobid for more than the total amount of the forecast shortage. The Bank of England normallyannounces the results within 15 minutes of the start of the round, publishing the total amountsallotted via repos and through outright purchase.

At the 9.45 a.m. round, the Bank of England normally does not relieve all of the forecastshortage (even if this amount is fully bid for) since it may need to revise slightly its forecastduring the course of the day in the light of updated information. A similar process is repeated atthe next round of operations at 2.30 p.m. The Bank of England publishes an update of the day’sforecast shortage as well as the residual shortage after allowing for liquidity supplied at the 9.45a.m. round. If there is still a residual shortage, a further round of bids is invited. By thecompletion of the 2.30 p.m. round, the Bank of England aims to have supplied the market withenough liquidity to enable all of the settlement banks to maintain positive balances on theiroperational accounts at the end of the day. In practice, however, further operations later in theday at 3.30 p.m. and 4.20 p.m. are sometimes required to achieve this because marketparticipants do not always bid for enough funds at 2.30 p.m. to relieve the residual shortage, orthere may be a late revision to the liquidity forecast.

The techniques described above are employed when the banking system is forecast to beshort of liquidity but very occasionally, a surplus of liquidity is forecast. If the forecast surplusexceeds a minimum threshold, tenders are held at both 9.45 a.m. and 2.30 p.m. or a single tenderis held at 2.30 p.m. The Bank of England makes an overnight lending facility available at 3.30p.m, if there is still a residual market shortage. The rate applied to these overnight repos is setnormally at 100 basis points above the official repo rate. This margin is intended to encouragethe market to participate fully in the principal rounds of two-week operations at 9.45 a.m. and2.30 p.m. At 3.30 p.m., the Bank of England makes available a daily overnight deposit facility.This provides counterparties the opportunities to place collateralised overnight deposits with theBank of England. It helps to moderate undue softness in overnight market interest rates at theend of the day. To ensure that this facility does not discourage active trading among marketparticipants, interest rate paid on overnight deposits is set normally at 100 basis points below theofficial repo rate. However, on days when there is a remaining shortage but there has been nolate change to the forecast (and, therefore, the settlement banks should reasonably have been able

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to draw the necessary funds from the Bank of England earlier in the day) funds are provided at ahigher rate, normally 150 basis points above the official repo rate.

Federal Reserve System (USA)

In January 2003, the Federal Reserve replaced two of its discount window programmes –adjustment credit and extended credit – with new primary credit and secondary creditprogrammes.

Primary Credit Programme

Under the new primary credit programme, Reserve Banks may extend short-term creditto eligible depository institutions at a rate of 100 basis points above the Federal Open MarketCommittee’s target for the Federal Funds rate. This spread may change in the light of experiencewith the new programme. The Board noted that an appreciable spread between the primary creditand target Federal Funds rate is necessary to prevent its inappropriate use at the expense of openmarket and also to do away with the need for administration of this window. An important goalof the primary credit programme is to reduce institutions’ reluctance to use the window as asource of back-up, short-term liquidity. The primary credit programme acts as the FederalReserve’s principal safety valve for ensuring adequate liquidity in the banking system.Generally, primary credit is extended on a very short-term basis, usually overnight. In somecases, primary credit may be extended for up to a few weeks to small institutions that meeteligibility requirements. In general, there are no restrictions on the use of primary credit. Theprimary credit programme does not require institutions to seek alternative sources of fundsbefore requesting occasional short-term advances. Except in unusual circumstances, ReserveBanks will not question depository institutions about their reason for borrowing primary credit.The institution must have the necessary collateral arrangements in order to utilize the primarycredit programme. An institution's supervisory examination rating and capital status largelydetermine its eligibility for primary credit. Given the confidential nature of CAMELS andStrength of Support Assessment (SOSA) ratings, regulators do not permit depository institutionsto disclose publicly their primary credit eligibility.

Secondary Credit Programme

Federal Reserve Banks may extend secondary credit to depository institutions that do notqualify for primary credit in order to assist in an institution’s timely return to a reliance ontraditional funding sources or in the resolution of its financial difficulties. This programmeentails a higher level of Reserve Bank administration and oversight than primary credit. Thesecondary credit rate is set at 50 bps above the primary credit rate. This spread is necessary asless sound borrowers are riskier and might have an incentive to use discount window borrowingsto expand their balance sheets in a manner that might distort resource allocation, and the higherrate on secondary credit is designed to reduce this incentive.

B. Emerging Market Economies

Mexico

The Banco de México is constitutionally mandated to ensure the stability of the nationalcurrency’s purchasing power. The central bank targets an inflation rate, presently 3 per cent CPIinflation. Monetary policy decisions are announced on predetermined dates, accompanied bypress releases explaining the reasons that motivate any changes to the monetary policy stance.While the Bank recognises that inflation is essentially determined by monetary expansion in themedium-term, the day-to-day monetary management essentially focuses on adjusting marketliquidity to impact monetary conditions, consistent with the market outcome.

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The Bank of Mexico follows a variant of the multiple indicator approach, monitoring awide range of economic indicators are monitored as a fundamental part of the inflation targetingframework. Although it no longer targets base money, monthly forecasts of the monetary baseare published monetary policy evaluation. The demand for the monetary base typically dependson a number of variables, such as economic activity, interest rates, the lags of the dependentvariable, variables explaining the presence of remonetisation in a scenario of declining inflation,and a set of dummy variables that try to capture all seasonal effects.

The Bank of Mexico uses, as its primary operational target, the average level of thebanks’ settlement balances with itself – the so-called Zero-Average Reserve RequirementSystem - and leaves the market free to determine the equilibrium interest rates. In order to signalits monetary policy intentions, it announces, on a daily basis, the level of the accumulatedbalance of total daily balances held by commercial banks with it for the end of the computationperiod.

The Bank of Mexico participates in the money market every business day as of noon.The Bank has previous information on all operations affecting the balances of commercialbanks’ current accounts, except for cash deposits or withdrawals made by credit institutions.This is so because the central bank credits (or debits) banks’ current accounts on the same daywhen, without prior notice, banks deposit the bills taken from the public in (or withdraw cashfrom) the Bank. Therefore, every day the Bank has to forecast changes in the demand for billsand coins in order to offset such changes by means of its intervention in the money market. Inorder to manage liquidity, the central bank intervenes in the money markets, offering credit,deposits or repurchase agreements, or carrying out direct purchases and sales of governmentsecurities through auctions.

The Bank’s monetary policy signals are interpreted in terms of the accumulated balanceprojections rather than the actuals. For example, a zero accumulated balances objective indicatesthe Bank's intentions to fully satisfy the demand for currency at market interest rates, andtherefore to supply the necessary resources for the entire banking sector so that the latter does notincur in overdrafts or accumulated unwanted positive balances at the end of the period. Anegative accumulated balances objective, i.e., a “short”, reflects the policy intention not tosupply the banking sector with all the funds requested at market interest rates. This action forcessome credit institutions to obtain part of the funds required through an overdraft in their currentaccounts.

Disregarding the possible effects of other variables, such action leads to a rise in interestrates, as financial institutions attempt to avoid paying the high rate charged on overdrafts in theircurrent accounts at the end of the period by obtaining the needed funds from the money market.This situation signals the market that the Bank has adopted a restrictive monetary policy. TheBank does not withdraw money from circulation when it adopts a negative accumulated balancesobjective as it always seeks to provide sufficient credit to satisfy the demand for bills and coins.

Thailand

Thailand switched its monetary policy framework from monetary targeting approach toinflation targeting (IT) approach with a target set for the core inflation, on a quarterly basis.Under the IT framework, the Bank of Thailand (BOT) implements its monetary policy by settingthe 14-day repurchase rate as the key policy rate. BOT signals a shift in its monetary policystance by an announcement of a change in the fortnightly repurchase rate. The BOT undertakesits financial market transactions for the purpose of the conduct of monetary policy through twoinstruments, viz., (a) daily repurchase market operations, and (b) foreign exchange swaps.

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Therefore, while the fortnightly repurchase rate acts as an interest rate signal, the dailyrepurchase rates are market determined. Thailand migrated from a pegged exchange rate regimeto a managed floating exchange rate regime in 1997 which has provided the BOT a greaterleeway for pursuing an independent domestic monetary policy. As there is no longer a need todefend specific exchange rate levels, direct foreign exchange intervention is thus limited.Whether and to what extent the monetary impact of such operations need to be sterilised dependson the assessment of overall liquidity and interest rate changes arising, inter alia, from Treasuryaccount flows, banking system's reserve position and maturing obligations of BOT. BOT acts asa banker to the Government. A system of primary dealers and selected financial institutions playa key role in the auction and distribution of government securities thereby providing the BOTanother channel of liquidity control.

Monetary conditions in Thailand during 2002 were influenced by continued increase innet foreign assets of the public sector due to foreign exchange acquisition by the authority, alower cash deficit of the Government and a reduction in BOT borrowing through the repurchasemarket during the fourth quarter to facilitate liquidity adjustment following settlement ofgovernment saving bonds. As the BOT followed a floating exchange rate regime, the capitalinflows into the Thai stock market, apart from other external factors, led to an appreciation of theThai baht by 3.3 per cent in 2002. The appreciation of the Thai currency was persistent only inthe first half of 2002, with the external factors driving the value down to some extent inSeptember-October 2002 before stability was restored in the last two months of the year. Theconduct of the monetary policy operations enabled the expansion of reserve money of Thailandin tune with the economic recovery. However, the money supply measures, M2A and M3showed a lower expansion than the base money consistent with the low inflation environment.

The year 2002 commenced with the prevalence of easy liquidity conditions in the Thaifinancial system and, thus, quite appropriately the fortnightly repurchase rate was reduced by 25basis points to 2 per cent in January 2002. This set the tone and pushed the overnight interbankrate down from 1.89 per cent in 2002 Q1 to 1.72 per cent in 2002Q2. The average one-dayrepurchase rate, which was below the overnight interbank rate, also decreased from 1.74 per centto 1.62 per cent during the same period. The money market rates dipped in the third quarter of2002 but the fortnightly repurchase rate was maintained at 2 per cent as the softening of theshort-term rates were on account of commercial banks making preparations since August 2002 inanticipation of settlement of government saving bonds in early September 2002. Expectedly afterthe temporary event-driven dip, the money market rates resumed their previous trend. However,as Federal Funds rate was reduced in the US and domestic perception of an easy monetary policytook ground, the fortnightly repurchase rate was reduced by 25 basis points to 1.75 per cent inNovember 2002 so as to signal softer interest rate conditions and facilitate recovery. As thepolicy rate was lowered, the overnight interbank rate and one-day repurchase rate automaticallyadjusted downwards to average at 1.67 per cent and 1.61 per cent, respectively, in the fourthquarter of 2002. Currently, the fortnightly repo rate, at a further reduced rate of 1.25 per cent, isdeemed to be low and a signal for an accommodative monetary policy stance. An importantfeature emerging from the BOT's conduct of liquidity management operations is that the BOTsets the 14-day repurchase rate and not the one-day repurchase rate; in fact, the latter along withthe other money market rates automatically adjust synchronously with the policy rate.Furthermore, the overnight interbank rate remained above the one-day repurchase rate.

China

Although the Chinese economy has performed well, the main problem facing it has beenan excessive expansion of its broad money at a year-on-year growth of 18.8 per cent in August

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2003, outgrowing the sum of GDP and CPI increase by 12.8 percentage points in the first half of2003. Liquidity prevailing in the Chinese financial system is reflective of an increase of foreignreserves. This has led to undue surge in credit growth of banks and financial institutions to ayear-on-year growth of 23.9 per cent in August 2003, the highest since August 1996. ThePeople's Bank of China (PBC)'s basic strategy in tacking the problem of excess liquidity hasbeen by conducting "sterilisation operations" through the issuance of central bank bills, whichare the short-term bonds issued by the PBC. Currently, financial institutions hold over RMB2trillion yuan worth of government bonds and financial bonds and over RMB400 trillion yuanworth of central bank bills. Although the issuance of central bank bills has been the maininstrument in managing short-term liquidity generated through foreign exchange inflows, thePBC recognises the 'sterilisation limit' of this instrument and therefore necessarily co-ordinatesthe issuance operation of central bank bills through an upward adjustment in the reserverequirements ratio. The reserve requirements came into existence in China in 1984 and has beenadjusted on six occasions including a slashing down of the ratio by 5 percentage points in March1998 and further by 2 percentage points to 6 per cent in September 1999. Recognising thesterilisation limit of the central bank bills in the context of ever increasing foreign exchangeinflows, the PBC raised the reserve ratio by one percentage point to 7 per cent on September 21,2003. Besides, these two instruments, the third instrument used by the PBC is the discountwindow. In the context of raising the reserve ratio, with a view to ensure that the rational creditrequirements do not suffer, the PBC would expand its refinancing and rediscount to maintain asteady credit growth.

The PBC views that the increase in reserve ratio will not impact stability in the moneymarket rates as the latter are set according to the demand and supply conditions and expectationsof the money market participants. Furthermore, the assurance of the PBC to implement a soundand consistent monetary policy together with flexible conduct open market operations accordingto the conditions of liquidity to adjust the frequency of issuance of central bank bills wouldfacilitate formation of stable expectations thereby fostering stable money market rates.

Korea

Under the revised Bank of Korea Act, effective April 1998, a paradigm shift in themonetary policy occurred when inflation targeting was introduced. The operating target shiftedto an overnight call money interest rate from the hitherto framework based on bank reserves withbroad money targeting. In the current scenario, broad money is now more of a monitoringvariable and not an intermediate target. Moreover, OMOs have come to take the most importantplace in the monetary policy toolkit.

The shift of operating target from bank reserves to the overnight call rate was notundertaken at a specific point of time; rather, it evolved as a part of policy response in theaftermath of the 1997 financial crisis, when interest rates were hiked for the defence of theexchange rate. From early 1999, the call rate consolidated its position as the operating target asmore stress began to be placed on the specific figure of the overnight call rate in the periodic“Monetary Policy Direction” statements.

Even as it transits to a purely market-based liquidity management framework, the Bankof Korea (BoK) continues to provide sector-specific refinance. To facilitate the signalling of itspolicy intentions as well as to stabilise the short-term interest rates, the BoK introduced LiquidityAdjustment Loan System in June 2000 with interest rate somewhat below the target overnightcall rate.

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The BoK has been lowering cash reserve requirements (CRR) in line with shift to indirectinstruments. Current reserve requirements average 3.0 per cent (varying in the range of 1-5 percent, depending on type of deposits); the Monetary Policy Committee is, however, empowered toraise CRR up to 50 per cent as well as impose marginal CRR of between 50% and 100%.Moreover, the BoK does not remunerate CRR balances (it used to do so till 1987), mainly on theground that (since the CRR balances can be used as settlement funds by banks free of charge),the cost to banks of maintaining CRR can be viewed as payment for this service by the BoK.

Table : Central Bank Lending Facilities in Korea

Facility Function Ceiling Rates Maturity

AggregateCredit CeilingLoans

Inducing banks to expand loans toSMEs

9.6 trillionwon

Belowtarget callrates

One month

LiquidityAdjustmentLoans

• Signalling of policy directionby flexibly adjusting lendingrates in accordance withmonetary policy direction

• Stabilisation of the financialmarket by promptly providingfinancial support in caseswhere banks face temporaryshortages of liquidity apply forborrowings

3 trillion won Belowtarget callrates (buthigher thanthat onAggregateCreditCeilingloans) #

No more thanone month

Loans ToMeetTemporaryShortages OfFunds

Supporting banks in meetingshortages of funds for paymentand settlement or reserverequirements

Within therange of fundshortages

Target callrate + 200bp

One businessday

Intra-DayOverdrafts

Supporting banks havingtemporary shortage of funds forpayment and settlement in thecourse of the day

200% ofaveragereservedepositsbalance withBoK

Interestfree

Close of thebusiness day@

Special Loans Lender of last resort Determined in each case

#: An additional rate of 100 bp is levied on banks that borrow for 3 consecutive months.@: If a bank fails to redeem the borrowings by the close of the day, the BoK converts it into loans tomeet temporary shortages of funds at a penalty rate.

The BoK forecasts the supply of reserves vis-à-vis demand for reserves and undertakesOMOs accordingly. The OMOs are mainly in the nature of repos rather than outrightsales/purchases. Since the volume of government and public bonds had been insufficient topermit OMOs, the BoK has been issuing its own bonds – Monetary Stabilisation Bonds (MSBs)– for more than four decades (since 1961). MSBs comprise a host of maturities (11 in all)starting from 14 days and going up to two years; the two years MSBs, however, dominate thetotal issuance, with a share of almost three-fourth in total. Outright sales have found little usesince they have the same effect as the issuance of MSBs; outright purchases, on the other hand,

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have been hampered by complex procedures relating to transfer of ownership. The ceiling on theMSBs has been progressively increased over time and, at present, these can be issued up to 50per cent of M2. As regards repos, although the longest repurchase maturity stands at 91 days, thematurities, in practice, are mainly within 15 days (which is the period for CRR maintenance).Most OMOs are carried out through a process of competitive bidding while MSBs are also soldover the counter at a set price. The BoK sets its reserve price (a reserve interest rate) when itinvites competitive tenders. When it sells repos or issues MSBs, the reserve price becomes thefloor (ceiling in case of interest rates) and vice versa for repo purchases.